The Securities and Exchange Commission (SEC) recently undertook an investigation to determine whether, among other things, an unincorporated "virtual" organization trading in token or digital currency violated federal securities laws. Based on the investigation, the SEC has offered important guidance on token and digital currency activities, ABA Section of Litigation leaders explain.
The Virtual Organization
In its Report of Investigation—a document the SEC can use to publish information concerning its investigation of securities law violations—the SEC explained that the virtual organization under investigation was a decentralized autonomous organization (DAO), "which is a term used to describe a 'virtual' organization embodied in computer code and executed on a distributed ledger or blockchain." The SEC further explained that the virtual organization's founders created it "with the objective of operating as a for-profit entity that would create and hold a corpus of assets" through the sale of virtual tokens, in this case known as "DAO Tokens," to investors, "which assets would then be used to fund 'projects.'"
The virtual organization offered and sold the initial DAO Tokens in exchange for Ether, a type of virtual currency. Holders of DAO Tokens stood to share in the anticipated earnings from the projects and could also resell their tokens on web-based platforms that supported secondary trading in DAO Tokens.
SEC Took a Broad View of What Constitutes a Security
"All securities offered and sold in the United States must be registered with the Commission or must qualify for an exemption from the registration requirements," the SEC noted. Thus, the threshold question the report addressed was whether DAO Tokens are securities.
Ultimately, the SEC found that the DAO Tokens were securities. The SEC considered a number of factors to reach its decision, including: (1) that investors in the organization invested "money," which "need not take the form of cash," (2) that investors purchased DAO Tokens with a reasonable expectation of profits through their investment in a common enterprise, and (3) that those profits were to be derived from the managerial efforts of others. The SEC did not conclude that all digital tokens will constitute securities.
Ultimately, "a security has to be registered unless it falls into some exemption, and the SEC is going to take a broad view of what constitutes a security," explains Joshua D. Jones, Birmingham, AL, cochair of the Section of Litigation's Securities Litigation Committee.
No Enforcement Action . . . This Time
The SEC declined to pursue an enforcement action in this case. However, the SEC emphasized that "the U.S. federal securities laws may apply to various activities, including distributed ledger technology, depending on the particular facts and circumstances, without regard to the form of the organization or technology used to effectuate a particular offer or sale." The SEC cautioned that the requirements to register or to qualify for an exemption "apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology."
After the DAO Tokens were sold but before the virtual organization began funding projects, an attacker used a flaw in the virtual organization's code to steal approximately one-third of its assets, the SEC explained. In response, the virtual organization's founders and others created a work-around that allowed DAO Token holders to opt to have their investment returned to them.
"Reading between the lines, you could speculate that at least one reason for not bringing an enforcement action is that there was no investor harm," says Jones. In short, "people could get their money back," he says.
Another possible explanation is that the virtual organization "went out of business as a result of this, so as a practical matter, there was no entity against which to bring an enforcement action at the end of the day," explains Vincent P. (Trace) Schmeltz III, Chicago, IL, cochair of the SEC Enforcement Subcommittee of the Section's Securities Litigation Committee. Schmeltz also hopes that the SEC viewed this as "an opportunity to give guidance and to be helpful to the market without doing it through enforcement."
Important Guidance from the SEC
In this case, the SEC "decided there was uncertainty as to if and how securities laws applied to token activities or digital currency activities," explains Grant P. Fondo, Menlo Park, CA, cochair of the White Collar & Corporate Investigations Subcommittee of the Section's Securities Litigation Committee, who agrees that the SEC used its report as an opportunity to offer guidance. Rather than get into a battle about disclosures and the applicable rules and regulations, the SEC "did what regulators often will do—issue guidance that to the extent there was confusion before, there should not be any confusion going forward," he adds.
Clients Should Proceed with Caution in Light of SEC Guidance
In light of this report, practitioners should advise their clients to proceed "with caution," advises Jones. While the SEC decided not to bring an enforcement action in this case, the next issuer "might not be so fortunate," he adds.
The analysis of whether something is a security is "relatively straightforward," explains Schmeltz, but people sometimes forget that new technology does not obviate the need to do that analysis. In this report, the SEC took fundamental principles of securities law and applied them to a new paradigm that was "never even considered when those principles were developed," Jones observes.
Many people think of cryptocurrency—a type of digital or virtual currency that uses cryptography, such as Bitcoin or Ether—as being relatively unregulated, Schmeltz says. Thus, they think of a coin offering as being a new form of technology that is also relatively unregulated, he explains. While it is a new form of technology, "the SEC has long been clear about how you think this through," Schmeltz explains. Even when using a new method or technology, "you have to focus on what has been done before," he adds.
"Too many people create, and create as though they are creating in a vacuum," Schmeltz says. Instead, before pursuing a coin offering, you must work through the analysis of whether what you are offering is a security, he advises. Practitioners may also advise clients that they may be able to work with the SEC's Distributed Ledger Technology Working Group, Schmeltz adds. The Distributed Ledger Technology Working Group is "willing to look at what people are doing and point them in the right direction" and "willing to have an ongoing conversation if guidance is needed going forward," Schmeltz observes.
A Word of Warning and Forecast of Continued Development
In sum, this report "could and should serve as a word of warning for practitioners and clients involved in this area," Jones says. In fact, it is "not unfair to read between the lines and say that it was intended by the SEC as a word of warning," he adds.
The SEC drew a "bright line" in its report, says Fondo. Anyone who engages in a token sale after the guidance issued in this report is now warned that if the token is a security or the SEC believes it is a security, "the SEC may come down on you," adds Fondo. Actions taken after this report will face more scrutiny than before July 25, 2017, Fondo notes.
Finally, there will likely be continual developments in this area, Jones says. In particular, the question of whether the platforms that trade in virtual tokens constitute "exchanges" within the meaning of the securities laws is a topic that the SEC will likely address again "at a later time in a later case," Jones adds.
C. Thea Pitzen is a contributing editor for Litigation News.